Question

2, Gamma Division of Fava Corporation produces electric motors, 20% of which are sold to Fava's Omega Division and 80% to outside customers. Fava treats its divisions as profit centers and allows division managers to choose whether to sel to or buy from internal divisions. Corporate policy requires that all interdivisional sales and purchases be transferred at variable cost, Gamma Division's estimated sales and standard cost data for the year ended December 31, based on a capacity o f 60,000 units, are as follows: Outsiders Sales Less: Variable costs Contribution margin Less: Fixed costs S660,000 S5.760,000 2.640,000 S3,120,000 900,00 660 ating income (loss) Unit sales Gamma has an opportunity to sell the 12,000 units shown above to an outside customer at $80 per unit. Omega can purchase the units it needs from an outside supplier for S92 each. Required: A. Assuming that Gamma desires to maximize operating income, should it take on the new customer and discontinue sales to Omega? Why? (Note: Answer this question from Gamma's perspective.) B. Assume that Fava allows division managers to negotiate transfer prices. The managers agreed on a tentative price of S80 per unit, to be reduced by an equal sharing of the additional Gamma income that results from the sale to Omega of 12,000 motors at S80 per unit. On the basis of this information, compute the company's new transfer price.

Answer 1

		Omega	Outside customer	Difference
	Sales	$660,000	$                  960,000	$300,000
	Less: Variable costs	660,000	660,000	-
	Contribution margin	$0	300,000	300,000
	Less: Fixed Costs	175,000	175,000	-
	Operating Income (loss)	($175,000)	125,000	$300,000
	Unit sales	12,000	12,000
A	Yes gamma should discontinue sale to Omega and should sell to outside customer
	It will increase its operating income by $300,000
B	Since sales made to Omega at tentative price of $80 per unit will increase its
	income by $300,000 and if want a transfer price than $150000 is to be shared
	with omega i.e. tentative price would reduce by (150000/12000 = 12.5)
	Tentative price	$          67.50
	(80 - 12.5)